Lesson 1: Introduction to Cash Flow Modeling

Actuarial Models in General

Actuarial models can be academically defined in many ways, such as: “A model is a set of verifiable mathematical relationships or logical procedures which is used to represent observed, measurable real-world phenomena, to communicate alternative hypotheses about the cause of the phenomena, and to predict future behavior of the phenomena for the purpose of decision making.”²

Complexity of an actuarial model vary by types of exercises required, from simple to complex. Generally:

• It requires a valuation date to indicate the starting point of calculation, which is normally month-end (or the monthly account closing date). When we perform actuarial valuation on a portfolio of in force policies, the valuation date used should be the same as the date when the policy data are extracted from the policy administration system.

As some vales associated to a policy may dynamically change over time (such as net asset value (“NAV”) for an investment-linked policy), the policy data we use in the actuarial studies should have be the “snapshots” as at valuation date.

• It carries out projections over a specific length of time (i.e. projection period). Variables are calculated repeatedly at different points of time. Due to technology advancement, projected cash flows are now calculated on monthly basis, instead of yearly. Furthermore, many actuarial values are calculated directly from the projected movements of policies and cash flows, without using actuarial commutation functions.

• It consists of many interdependent variables. Results calculated by a particular variable may be used by other variables. Normally, final results that appear in an actuarial report, such as reserves, cannot be determined using straightforward formulas. Instead, we breakdown the calculations into many smaller calculations, serving as intermediate variables. For example, before we derive the reserve for a particular policy, we need to calculate premium income and claim outgo separately for the remaining policy term.

2| Modern Actuarial Theory and Practice By Philip Booth, Robert Chadburn, Deborah Cooper, Steven Haberman, Dewi James (Page 593). Published by Chapman and Hall/CRC, October 20, 1998.